What Are Crypto Derivatives and How Do They Work?

By Gaurav Roy

Have you ever heard of crypto derivatives and wondered what they are all about? 

With the rise of cryptocurrencies, derivatives have emerged as a popular tool for traders to manage risk and speculate on the price movements of digital assets. 

But with their complex nature and potential risks, it’s important to understand the ins and outs of the crypto derivatives market before diving in. 

But wait, Derivatives have been around for ages, right? Indeed, ancient civilizations used derivatives. For example, in Mesopotamia, clay tablets described futures contracts used for agricultural goods. Even in the 19th century, Chicago became a hub for derivatives trading. But now, there are even derivatives for cryptocurrencies.

In this article, Ledger takes a deep dive into the world of crypto derivatives, exploring what they are, how they work, and what you should know before getting involved. So buckle up and get ready to learn all about this rapidly evolving corner of the crypto world.

What are Crypto Derivatives?

Crypto derivatives are financial instruments that derive value from an underlying crypto asset. They are contracts between two parties that allow traders to speculate on the price movements of cryptocurrencies without actually owning the underlying asset. As such, the trader makes a profit or loss depending on whether the asset price goes up or down.

Today, there are specialized cryptocurrency exchanges, as well as traditional financial exchanges offering crypto derivatives, but what’s the point?

Why Trade Crypto Derivatives?

Crypto derivatives are primarily used for speculation, hedging, and leverage.

Speculation

The speculation involves taking a position on the future price movements of crypto to make a profit. This allows traders to take advantage of the high volatility of the crypto market, as it can help them earn significant profits if they correctly predict the future price movements of the underlying asset. This way, traders can capitalize on market opportunities by going long or short.

While spot trading also allows speculation — buying low and selling high — leverage is what makes derivatives attractive to traders.

Leverage Trading

Leverage trading is the ability to control a large amount of an asset with a relatively small amount. For example, a trader may only need to put down 10% of the total value of a futures contract. For instance, on the crypto exchange Binance, a trader can leverage up to 125 times the initial margin. But while leverage can amplify potential profits, it also drastically increases the risk of losses.

Hedging

Hedging is another reason for using crypto derivatives. It is a risk management strategy where a trader takes an opposite position to an existing one to offset potential losses. For example, a Bitcoin spot holder buys an asset and then holds it until the value (hopefully) increases. However, if they think the asset might decrease in value, they can take a short position on a Bitcoin futures contract, effectively hedging their position.

Types of Crypto Derivatives

Crypto derivatives operate similarly to traditional derivatives, where a buyer and seller enter into a contract to sell an underlying asset, with the asset being sold at a predetermined time and price. 

Derivatives do not have any value. Instead, they derive their value from the underlying asset. For example, the value of a Bitcoin derivative is determined by the value of Bitcoin. 

So, what kind of derivatives are available in the crypto market? The most commonly traded types of derivatives include futures, options, and perpetual contracts.

What are Crypto Futures?

Crypto futures are a type of derivative contract that allows two parties to agree on the price of a cryptocurrency at a fixed date in the future. Upon expiration of the contract, the buyer is obligated to receive and purchase the asset, while the seller is obligated to deliver and sell the asset.

In today’s financial and crypto markets, physical delivery of the asset does not always occur with futures contracts. Instead, the profit or loss arising from the trade is typically settled in cash and credited or debited to the trader’s account. 

When entering into a futures contract, traders can take a long or short position, indicating the direction they believe the asset’s price will move. 

A long position is when a trader believes that the underlying asset’s price (e.g., Bitcoin) will increase in the future. A short position, on the other hand, is when a trader believes that the underlying asset’s price will decrease in the future.

Perpetual Futures

Perpetual futures are a type of futures contract without an expiration date. Instead, perpetual futures contracts remain open indefinitely until the trader closes the position. This means traders can hold a perpetual futures position for as long as they want, potentially profiting from long-term price movements in the underlying asset.

These futures contracts work by using a funding mechanism that helps keep the contract price in line with the spot price of the underlying asset. the difference between the perpetual futures price and the spot price of the underlying asset determines the funding rate

For example, if the price of the perpetual contract exceeds the index price, traders who have taken a “long” position typically pay the funding rate to compensate for the price difference. Conversely, if the perpetual futures contract price is lower than the index price, traders with a “short” position pay the funding rate.

What Are Crypto Options?

Crypto options give the holder the right, but not the obligation, to buy or sell a specific amount of a cryptocurrency at a predetermined price (known as the strike price) on or before a specified date. 

But remember, there are several fees involved in trading options derivatives:

Options premium: The cost paid by the buyer for the right to trade at a set price.

Commission: A fee charged by brokers per options trade, either flat or percentage-based.

Contract fees: Small fees charged by exchanges for each option’s contract, paid by both parties.

Exercise fees: A fee charged by brokers if the option is exercised.

Margin interest: Interest charged on borrowed funds used in options trading.

Bitcoin Options: Call and Put

There are two types of Bitcoin options: call options and put options. 

A call option gives the holder the right to buy crypto at a predetermined price, while a put option gives the holder the right to sell at a predetermined price.

For example, if a trader thinks that the Bitcoin price will rise in the future, they purchase a call option with a strike price of $100,000 that expires in three months. And if BTC exceeds $100,000 before expiry, the trader may use the option to buy at a lower price and possibly book a profit.

In both cases, the trader pays a premium to purchase the option, representing the option contract’s price. However, if Bitcoin’s price doesn’t follow the trader’s prediction, they can allow the option to expire, only losing the paid premium.

What Is the Impact of Derivatives Trading?

Derivatives, in general, are crucial in establishing a mature financial system. They enable market participants to manage risk, enhance liquidity, and enable price discovery, all of which are essential for market growth and development.

Liquidity is a critical component of the crypto sector, much like any financial market. After all, without liquidity in a system, prices become more volatile. 

A lack of liquidity can result in wider bid-ask spreads, increased volatility, and higher transaction costs, making it difficult for traders to enter and exit positions at desirable prices. It can also deter institutions, which typically require a certain level of liquidity to put in large sums of money.

In contrast, high liquidity attracts more market participants, facilitates efficient and transparent market development, and reduces the likelihood of market manipulation. 

Derivatives also allow traders to hedge their risks and manage their portfolios more effectively, increasing market efficiency. Furthermore, limiting traders’ losses allows them to make more rational trading decisions.

Furthermore, derivatives trading can optimize price discovery by providing additional market data that informs price trends and market sentiment.

Benefits and Risks of Trading Crypto Derivatives

Trading derivatives come with its own pros and cons that traders must be aware of to effectively manage their trades. 

Benefits

Traders can derive multiple benefits from trading crypto derivatives. For starters, it is cheaper than spot trading. 

Moreover, derivatives can help traders mitigate the risks of an underlying asset’s price fluctuations. To explain, using derivatives for hedging helps traders limit losses in the event of an adverse price movement. 

Derivatives trading also enables leverage, allowing traders to control larger positions with a smaller amount of capital — hence magnifying the potential gains. Additionally, derivatives facilitate portfolio diversification, meaning traders can maximize their returns and manage risks more effectively. Trading derivatives across various assets can reduce individual market risks and achieve a more balanced portfolio. 

Risks

Crypto derivatives carry several risks, including the risk of volatility. Derivatives trading involves speculating on the price movements of an underlying asset that can be volatile. Leverage trading magnifies this risk: You could potentially incur significant losses.

Another risk is the unclear legal status of derivatives trading in some jurisdictions. You wouldn’t want your trading strategies to result in potential legal and compliance risks. In fact, it’s illegal in certain countries. Accordingly, traders must check the laws and regulations of their country before engaging in derivatives trading. 

There are also counterparty risks associated with over-the-counter (OTC) derivatives trades, as traders may not benefit from the due diligence that comes with trading on regulated exchanges. For example, OTC trades expose traders to credit and default risks.

Best Practices in Trading Crypto Derivatives

It is important to note that there is no guaranteed way to make money trading derivatives in the crypto market, and it can be a highly risky endeavor. However, there are some ways traders minimize risks and maximize their chances of success.

Common Tactics

Trading derivatives can be highly complex, and there is no one-size-fits-all approach to success. That being said, traders may use common tactics when trading derivatives, depending on their market outlook and risk tolerance.

For example, in a bull market, traders may use option contracts to buy at a certain price (a “call” option), allowing them to benefit from further upward price movements. Similarly, in a bear market, traders may use options contracts to sell at a certain price (a “put” option), providing a hedge against further price drops.

Other tactics include using technical analysis to identify trends and price patterns and using leverage to amplify potential profits.

Manage Your Risk

When trading crypto derivatives, it is important to manage your risk carefully. Crypto prices are volatile, and since crypto derivatives drive their value from underlying assets, they are subject to the same volatility. Furthermore, leverage trading only amplifies that risk. So, traders should only use it if they understand how it works and they are comfortable with the potential risks.

Traders also manage their risk with specific tools such as stop-loss orders. To explain, this tool will automatically sell a position if it reaches a certain price, limiting potential losses. Additionally, traders often diversify their portfolios across different assets to avoid overexposure to any one position or asset.

DYOR Before Trading Crypto Derivatives

DYOR, or “do your own research,” is crucial to successful trading in any market, including the crypto derivatives market. By conducting your own research and analysis, you can better understand the market, the assets you are trading, and the potential risks and rewards involved.

Making informed decisions in the crypto derivatives market involves research. Before you go ahead, make sure to read about the intricacies of crypto trading and how to segregate your assets, should you wish to partake.

If you’re fully informed and ready to go, interacting with the DeFi scene is easy with the Ledger ecosystem.  Ledger Live offers several crypto trading apps which allow you to buy, sell, lend and borrow in one single place.  Then, this powerful app works together with your trusty Ledger device, allowing you to interact with the DeFi ecosystem, while staying protected from online threats. 

With all of these pieces together, exploring the crypto market has never been so secure.